Real Estate Mortgage Foreclosures and Related Remedies

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           Real Estate Mortgage Foreclosures
                           and Related Remedies

A creditor holding a lien in real estate collateral, such as a mortgage, deed of trust, or an assignment of rents,
will be faced with the decision whether to liquidate its collateral when the commercial borrower defaults
under its loan and security agreements. The secured creditor may make this decision after a previously nego-
tiated workout agreement with the borrower has failed. Alternatively, the secured creditor may decide that,
upon the debtor’s first default, an attempt to restructure the secured indebtedness would not be in the se-
cured creditor’s best interests.
      The first issue that the foreclosing real estate lender will be required to address is what law will govern
the foreclosure and liquidation process. In most cases, the law of the situs of the real estate will be applied by
a court to determine the nature of the lien created and the requirements and consequences of foreclosure,
such as the procedure applicable to foreclosure actions and the determination of whether and to what extent
a deficiency judgment against the borrower and any guarantors may be entered. Restatement Second,
Conflict of Laws §§228-230 (1969). Unlike state law governing personal property foreclosures, the law of
the 50 states concerning foreclosure of mortgages and deeds of trust, the exercise of rent assignments and
other procedures for liquidation of real estate collateral is not uniform. Some states permit foreclosure of
mortgages only by judicial action while others permit nonjudicial foreclosure when a power of sale is con-
tained in the mortgage. Some states do not grant any redemption rights to the mortgagor and other parties
with interests in real estate. Other states, notably California and Washington, prohibit a foreclosing mort-
gagee from recovering a deficiency judgment against the mortgagor in certain circumstances. Given this wide
spectrum of state law, any real estate lender who desires to realize upon its collateral should first retain coun-
sel in the jurisdiction in which the realty is located to obtain proper legal advice concerning the lender’s
available options and their attendant benefits and risks.

                                  §4.02 THE REAL ESTATE
                             LENDER’S POST-DEFAULT CHECKLIST
§4.02(a) Collection And Analysis Of Documents
       Promptly after the real estate borrower defaults, the lender and its counsel must perform careful due
diligence concerning the credit and security agreements and the collateral itself. The first step in this process
is for the lender and its counsel to collect all of the agreements and other documents involving the borrower,
the lender, and any third parties relating to the defaulted real estate loan. Creditors sometimes maintain
these documents in separate “credit” or “collateral” files at their offices. The secured creditor and its counsel
must make certain that they secure and review all of these documents. Once this collection and review proc-
ess has been completed, creditor’s counsel should interview the individuals responsible for administering the
defaulted loan and any other persons who played prominent roles in the credit, such as prior loan officers and
their superiors. The identities of these various individuals may often be obtained from a review of the loan

§4.02(b) Documents Evidencing The Secured Debt
      The first categories of documents that the lender and its counsel must focus upon are those that evidence
the indebtedness secured by the real estate collateral. In many, if not most, instances, these documents will
include promissory notes containing the borrower’s promise to pay the debt. If a letter of credit has been is-
sued by the secured creditor to a third party, the evidence of this indebtedness may be contained in a reim-
bursement agreement that obligates the customer to pay the issuing bank for any draws made under the letter
of credit. In reviewing the documents evidencing the secured debt, counsel must determine whether those
documents have been properly executed by the borrower. Did an authorized officer or other representative
execute the promissory note or other evidence of indebtedness? If the borrower is an artificial person, such as
a corporation, partnership, or limited liability company, was the execution of that document properly author-
ized by resolutions of the borrower’s board of directors, its partners or members? Finally, the lender and its
counsel must calculate the total amount of the indebtedness secured by the real estate collateral. In making this
calculation, the following elements comprising the debt must be determined: unpaid principal and interest,
late charges, prepayment penalties, yield maintenance premiums, fees of professionals (e.g., attorneys, sur-
veyors, appraisers, and environmental engineers) and any other related costs and expenses of collection. If any
protective advances were made by the mortgagee after default, e.g., to purchase insurance, pay real estate
taxes or make necessary repairs to the collateral, these sums may be included in the mortgage debt if author-
ized in the loan and security documents. See Form 4.1 for a sample spread sheet for calculation of the mort-
gage indebtedness.

§4.02(c) Security Documents
       The next focus of the lender’s due diligence should be a careful review and analyses of the security
documents themselves—the mortgage, deed of trust, and any assignment of rents and leases. Have these
documents been properly executed by the mortgagor and have the required signatures been notarized? Is
there any evidence of recording in the proper land records contained on the documents themselves, such as a
date stamp by the register of deeds and a liber and page number for the recorded document? The lender
should also determine whether any third-party credit enhancements exist. Have any other entities guaranteed
the payment or collection of the mortgage debt? Have these guarantees been properly executed and are they
still in force? Are there any standby letters of credit issued for the benefit of the mortgagee that may be
drawn upon to pay the secured debt?

§4.02(d) Contractual Default Provisions
      Once the debt instruments and collateral documents have been collected, organized, and analyzed, the
lender must then carefully review the default provisions contained in these papers to confirm that a default
has occurred, thereby permitting acceleration of the secured debt. Each default should be identified and
listed. Common events of default include the borrower’s failure to pay monthly installments of principal and
interest when due, the foreclosure by another creditor of its interest in the real estate collateral, the failure of
the mortgagor to pay taxes assessed against the realty, the failure of the mortgagor to maintain necessary in-
surance on the property, and the mortgagor’s bankruptcy or insolvency. See Form 4.2 for a sample mortgage
default clause. Once the events of default have been identified, the mortgagee must determine whether there
are any time periods within which the mortgagor may cure the defaults, commonly known as “cure periods.”
Is the mortgagee required to notify the mortgagor of the existence of a default and give the mortgagor the
opportunity to cure that default prior to accelerating the debt? If so, what type of notice must be sent? When
performing this review, the mortgagee should determine whether it has extended any other credit facilities
to the mortgagor and, if so, whether those credit documents contain a “cross-default clause” that would re-
sult in the mortgagor’s default under these other facilities.

§4.02(e) Financial Information
      The mortgagee should collect and analyze all recent financial information that it possesses relating to
the mortgagor. The mortgage loan documents will often require the mortgagor to submit certain financial
information to the lender on a periodic basis. Examples include balance sheets, profit and loss statements,
real estate tax bills, income tax returns, and tenant rent rolls. The lender may also have in its loan files a sur-
vey of the mortgaged realty and an appraisal of that property. If the mortgage requires the mortgagor to ob-
tain insurance on the collateral, evidence of this insurance, such as copies of binders and actual policies,
should be obtained and reviewed by the lender. All of this information will be critical to the lender in making
its determination whether or not to foreclose on its real estate collateral.

§4.02(f) Environmental Liability Risks
       Federal and state law may impose liability for the cleanup of toxic substances upon a lender that fore-
closes upon real estate collateral and becomes its owner or upon a lender that controls the borrower’s deci-
sions concerning the disposal of its toxic waste. The primary federal laws that impact real estate lenders are
the Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”), 42 U.S.C.
§9601-9657, enacted by Congress in 1980 and the Superfund Amendments and Reauthorization Act of 1986
(“SARA”), 42 U.S.C. §9611. CERCLA imposed upon “owners and operators” of real estate liability for the
costs of cleaning up environmental pollutants subject, however, to the “innocent purchaser and “innocent
landowner” defenses established by CERCLA and SARA. Some state legislatures have supplemented these
federal statutes by creating liens in favor of the state agencies to enforce the cleanup of hazardous wastes.
These liens may have the priority of a tax lien or may prime existing mortgages and other liens on the subject
property. See, e.g., N.J. Rev. Stat. 58:10-23.11 to 58:10-23.112; Conn. Gen. Stat. 22a-452a; Mass. Gen.
L. c.21E, 13.
       In determining the appropriate workout or foreclosure strategy for a lender holding a lien on contami-
nated realty, counsel should carefully consider the following factors:
       (a) Has the lender been actively involved in the management of the borrower’s business enterprise such
that the lender influenced decisions concerning the disposal of hazardous wastes? This inquiry is relevant to
the issue of whether the secured lender is an “operator” of the contaminated facility for purposes of CERCLA
liability. For such liability to be imposed, there must be actual participation in management and not merely
the unexercised capacity to influence or control disposal decisions. 42 U.S.C. §9601(20)(E)-(F).
       (b) At the time the loan was made and at any time thereafter, what notice or knowledge did the lender
have of any actual or threatened releases of hazardous substances on or in connection with its real estate col-
lateral? Has the lender conducted “appropriate inspections” of the property, e.g., through an environmental
audit before the loan closing or afterwards? Because of the development of the law since the passage of
CERCLA, real estate lenders are required to exercise substantial due diligence concerning environmental
hazards prior to making and closing a loan. This due diligence includes inspecting parcels adjacent to the col-
lateral, requiring indemnities for environmental liability from the borrower and guarantors, and conducting
environmental audits performed by third-party experts. These inquiries are relevant to whether a foreclosing
lender can rely upon the “innocent purchaser” and “innocent landowner” defenses contained in 42 U.S.C.
      If the collateral is contaminated with hazardous substances at the time of the borrower’s default under
the loan agreement, the lender should be extremely cautious before making a decision to foreclose on the
real estate and bidding in its indebtedness to purchase the property at the subsequent sale. This area of juris-
prudence is extremely technical and lenders should seek expert advice from their counsel when addressing
these issues. If the lender cannot avail itself of the “innocent landowner” or “innocent purchaser” defenses
under federal law, then the lender should consider alternative workout and foreclosure strategies including
foreclosing on other collateral and attempting to collect the indebtedness from guarantors. Additionally, the
lender should determine whether it may foreclose and sell only the parcels of real estate that are not con-
taminated by hazardous substances.

§4.02(g) Multilender Transactions: Loan Participations And Syndications
      In credit transactions with a borrower involving multiple lenders, the various lending institutions must
determine what their rights are vis-à-vis the obligors and the collateral for their loans and advances in a
default situation. As discussed in more detail in Chapter 5, groups of lenders often extend credit facilities of
significant size to commercial borrowers; these facilities may contain revolving credit loans, term loans, and
availabilities for letters of credit. There are two primary structures for these multilender transactions: loan
participations and loan syndications. A loan participation involves only one loan made by the lead lender to
the borrower, who then sells participations in that loan to other financial institutions, thereby spreading the
risk of a default among other banks. The participants normally will not hold any rights against the borrower
or any security interests in the collateral; only the lead lender will be entitled to enforce the terms of the loan
and security agreements, by means of foreclosing on its liens and other interests in the real estate collateral.
The lead lender will, nevertheless, be bound to share collections and other recoveries with the participants in
accordance with the terms of a participation agreement. The lead’s failure to adhere to the terms of this
agreement may give rise to a breach of contract action by the participants against the lead.
      The other commonly used vehicle for multilender credit transactions with commercial borrowers is the
loan syndication. Unlike participations, all of the lenders will have a direct debtor-creditor relationship with
the borrower and any other obligors, which is normally evidenced by separate promissory notes made pay-
able by the debtor to each lender in the syndicate. Nevertheless, the loan agreement and perhaps other
documents will regulate the relationships among the various lenders. These documents will address how loan
collections are to be allocated among the lenders and, in default situations, what actions may be taken by the
lenders to enforce their liens and security interests in collateral and under what circumstances.

§4.02(h) Determination Of Lien Priorities In Real Estate Collateral
      Before a lender commences proceedings to foreclose on its liens and other interests in real estate collat-
eral, it will be absolutely necessary for that lender to determine the relative priority of its liens vis-à-vis
other interests in that property. In the first instance, this lien priority analysis will influence the lender’s deci-
sion whether to foreclose and how it should be done. In performing this analysis, the lender should obtain a
lien search on its collateral to ascertain what other interests are of record in the collateral. In most cases, the
lender will have obtained when the loan was made a policy of insurance from a title company insuring that its
interest as mortgagee was of record and specifying any other interests in the collateral as exceptions to cover-
age. Upon the borrower’s default, the lender should retrieve a copy of this policy or marked title commit-
ment along with any subsequent updates from its loan and collateral files and then request that the insurer
perform and deliver a current lien foreclosure search on the collateral to determine what liens and other in-
terests have attached to the property after the loan closing.
      Upon receipt of the results of the lien foreclosure search, the lender must determine the nature and
extent of any liens or other interests in the real estate that are senior to its own interests. For example, if the
mortgagee’s lien is junior to another mortgage, the lender should obtain a payoff amount from the senior
mortgagee. State law often affords priority to any liens for unpaid real estate taxes, special assessments, and
water and sewer charges. These liens and their amounts should be disclosed by the lien foreclosure search
results. State law may also grant priority to certain mechanics’ liens recorded against the real estate. In addi-
tion to the search results, the foreclosing lender must determine whether it has consensually subordinated its
mortgage lien or other interest to a junior lien in the collateral. These subordination agreements or notice of
their existence are often recorded in the land records and copies should be contained in the lender’s collat-
eral file. In addition, the lender must determine whether and to what extent its lien for any future advances
made under the mortgage loan documents is senior to other liens on the property; this result will be deter-
mined by applicable state law. This information will be critical in influencing the lender’s decision whether
to foreclose on its real property collateral and in what manner. See §4.03 for an explanation of how to de-
termine lien value and the foreclosure sale bid price.

§4.02(i) The Impact Of The “One Action Rule” Upon Foreclosure Strategy
       Several states have adopted legislation embodying the “one action rule” concerning foreclosure of mort-
gages and deeds of trust in real estate collateral. This rule generally requires that, upon a default, the mort-
gagee’s sole remedy will be a foreclosure action and that any deficiency claim must be asserted in the context
of that proceeding. The California statute is a prime example of this legislation and reads as follows:
There can be but one form of action for the recovery of any debt for the enforcement of any right secured by
mortgage upon real property, which action must be in accordance with the provisions of this chapter. In the
action the court may, by its judgment, direct the sale of the encumbered property.
West’s Ann. Cal. Code Civ. Pro. 726(a). Similar legislation has been adopted in Idaho, Montana, Nevada,
Utah, and New Jersey.
       The one action rule is primarily supported by two public policy considerations. The first is to protect
the mortgagor from a multiplicity of actions when separate actions for foreclosure of the mortgage and impo-
sition of an in personam judgment for any deficiency, can and should be decided in one civil action. The
other public policy objective is to compel the mortgagee to exhaust its security before attempting to execute
upon any unmortgaged property in satisfaction of the debt. Other states have adopted similar legislation that
requires the mortgagee to foreclose on its mortgage pursuant to the exercise of a power of sale before com-
mencing any action against the mortgagor to obtain a deficiency judgment. States that adopted this “security
first” legislation include Florida, Minnesota, New York, and Washington.
       If the real estate lender holds a mortgage or deed of trust that is the subject of a “one action” or “secu-
rity first” legislation or judicial rule, then that lender must comply with the requirements of that rule as it
exists in the relevant jurisdiction or risk jeopardizing its claim for a deficiency against the borrower and any
other obligors. These rules may also influence the timing and sequence of foreclosure actions when a single
promissory note is secured by mortgages or deeds of trust on real estate in several jurisdictions, including
states that have adopted “one action” or “security first” rules.

§4.02(j) Real Estate Collateral Subject To Third Party Leases
      Many commercial real estate loans are secured by real estate that is subject to third-party leases, such as
apartment projects, office buildings, and shopping malls. Lenders holding a mortgage or deed of trust in the
owner’s fee interest in the real estate may also obtain an assignment of rents and leases from the owner as
additional security for the loan. If applicable state law permits, the lender will be entitled, upon the bor-
rower’s default, to execute upon this assignment by directly collecting rents due from tenants to the owner.

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